Leeway on Repo Rules Is Cut Back

Accounting-rule makers took another step Tuesday to close a loophole that Lehman Brothers Holdings Inc. and MF Global Holdings Inc. used to make themselves appear healthier before the brokerage firms collapsed, costing investors billions of dollars.

The Financial Accounting Standards Board proposed to further tighten the accounting for so-called repo financing, in which securities-trading firms borrow money and put up securities as collateral with the promise to buy them back later. Repos, or repurchase agreements, are commonly accounted for as borrowings, but Lehman and MF Global classified some of their repo transactions as sales. Authorities say that decision assisted them in the abuses that led to their collapse.

The new proposal is intended to make such abuses much more difficult. Under the plan proposed by the board, which writes U.S. accounting rules, almost all repos would be treated as borrowings. The proposal significantly narrows the circumstances under which they could be treated as sales.

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In particular, "repos to maturity," a variant of traditional repos that MF Global used and which currently can be treated as sales, would lose that status and be classified as borrowings under the new FASB proposal.

"At this point, we're basically saying all repos should be accounted for as borrowings," FASB Chairman Leslie Seidman said. Investors told the board they wanted more stringent repo accounting after events like the Lehman and MF Global failures, she said.

The proposal is FASB's second attempt to revamp repo accounting after Lehman's collapse—the board previously tightened its rules in 2011.

The proposal is still in its early stages and is subject to public comment and possibly reconsideration by the board before it is finalized.

While the FASB's move is intended to protect against any potential future attempts to game the repo rules, it is unclear what the practical effect will be. A search of regulatory filings didn't turn up any firms that currently have more than relatively small amounts of repos classified as sales.

Repo accounting first drew attention after the 2008 collapse of Lehman Brothers, when Lehman used transactions dubbed "Repo 105s" to help make it appear healthier than it really was, according to a later report by Anton Valukas, the firm's bankruptcy examiner. Lehman treated its Repo 105s as sales, which allowed it to take as much as $50 billion in assets off its balance sheet at the end of certain quarters, making it look less leveraged.

MF Global had billions of dollars in repo-to-maturity trades, which extend the duration of the repo financing so that it matures at the same time as the securities used as collateral.

The firm's classification of those trades as sales enabled it to book immediate profits on the transactions, but the trades later created margin demands that placed stress on the firm's cash, according to bankruptcy examiner James Giddens's report. (In fact, Mr. Giddens found, the firm's repo-to-maturity trades actually ended two days short of the pledged securities' maturity.)

MF Global's repo-to-maturity trades, backed by risky European sovereign debt, helped prompt regulatory concerns, ratings downgrades and margin calls that helped lead to the firm's 2011 collapse after it ran short of funds.

MF Global's accounting was "basically just trying to cover up risk," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. The firm "should not have been able to characterize it as a sale."

Some other securities firms also were using repos-to-maturity at the time, though none as pervasively as MF Global. They pared back their exposure or disclosed more information about the trades to try to reassure nervous investors after MF Global's implosion.

FASB's proposal also would require companies to disclose more details about what kind of collateral is backing their repo borrowings. In addition, if a firm classifies any repos as sales under certain circumstances, it would have to disclose how much in assets it has taken off its balance sheet as a result and the reasons for any significant changes in that amount.

The accounting board is seeking comments on the proposal by March 29. The board hasn't yet indicated when its proposed moves might take effect.

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